How Can You Rebuild a Broken Retirement Three-Legged Stool?

The road to retirement is not as straightforward as it used to be. There was a time when simple metaphors, like the three-legged stool of retirement, captured how you could achieve retirement security with ease. This concept illustrated how securing a good pension, obtaining a solid return on your savings, and relying on social security might have paved the way for financial comfort in your golden years.  Relying on just one leg could lead to failed retirement goals, while relying on two legs requires a delicate balancing act.

Unfortunately, for many individuals, this seemingly secure approach to retirement planning has all but disappeared. And today, few simple metaphors exist to describe an easy path toward retirement security, leaving many people scrambling to figure out how to plan for their future thoughtfully. Now, with a little extra work and some creativity, you might be able to repurpose the components of the simple three-legged stool framework to suit your individual goals in this complex and challenging economic environment.

The Three Legged Stool of Retirement
Source: Broadview Macro Research

How the Three-Legged Stool Has Changed

When the three-legged stool concept was first introduced generations ago, many employers provided pension benefits to their employees, banks offered healthy returns on savings, and social security was seen as a solid base from which to structure retirement planning. Yet the foundation upon which this concept was developed has materially changed in the past few decades.

 

Complex Retirement Planning

For example, defined benefit pension plans used to be a key component of the three-legged retirement stool. Pensions accounted for 70% of retirement plans in 1975 for companies with 100 or more employees. By 2017, this figure fell to 9% and remains in decline as employers increasingly shift their preference toward defined contribution options like 401(k) and 403(b) plans.  

 

This change means that individuals workers are increasingly responsible for navigating sophisticated investment options, determining appropriate contribution amounts, and working through tax consequences and their crucial distribution choices. It goes without saying that planning for retirement is much more complicated than it used to be.

Source: Broadview Macro Research

More Challenging to Grow Your Money

In terms of saving for the future, changes in the financial system have made it challenging to grow your money through a simple bank deposit. From 1980 through the start of the Global Financial Crisis, bank deposit rates averaged 6.5%. Since then, the amount of annual interest that your savings might accumulate through a bank account has fallen to less than 1%. Without a doubt, using a simple savings account to shore up your retirement is more challenging.

 

For example, at the current average deposit rate of 0.5%, it will take you 144 years to double money held in a savings account compared to just 11 years a few decades ago. Taking into consideration the detrimental effects of inflation, if you rely on a standard bank account alone to grow your wealth, there’s a good chance that a dollar saved today likely won’t go as far in the future.

 

Social Security is Less Secure

Finally, it will likely come as no surprise that expected future social security benefits are increasingly coming under pressure. Social Security was once seen as the most solid leg of the retirement planning stool. Yet, by some estimates, the government’s reserves needed to pay old age, survivor, and disability insurance (OASDI) benefits for Americans likely will be depleted by 2035. This outlook is according to a report from the Social Security Trustees themselves.

 

What’s clear is that Congress must act soon to prevent the Social Security program from going bankrupt. While this entitlement program surely remains an important political debate topic, the program we know today might likely look much different in the future. This view underscores yet another set of uncertainties about how income benefits will be calculated for individuals paying into the program today to draw down benefits decades from now.

 

Given this backdrop, you can likely see how the three-legged stool that had helped many individuals secure retirement in the past is now less secure for future generations. So, what can you do to secure your retirement plan in light of this crumbing three-legged stool?  

 

While the task at hand will not be easy, there are a few things that you can do to repurpose some of the original intent behind the three-legged stool to overcome today’s retirement planning obstacles. Let’s start by examining how you can maximize the benefits of your employer retirement plan.

Source: Broadview Macro Research

From Pension to Self-Directed Retirement

As discussed earlier, companies are increasingly offering their workers retirement benefits through defined contribution plans, like 401(k) and 403(b) accounts. These plans require substantially more involvement from their workers. And because defined contribution plans put the retirement savings onus in your court, one of the most vital things you can do to rebuild this critical component of the retirement stool is to begin saving as soon as possible.  

 

In a previous report, we showed how a steady contribution rate, a modest return, and little time could help you grow your savings for the long term. So, what difference can a few years make? And why should you get started early? Rather than telling you about the benefit, let’s look at an illustration that lays out the opportunity cost of delaying retirement savings.

 

Let’s assume that you contribute $500 per month towards your defined contribution account, starting at the age of 25 with a plan to retire at 70. Earning an average return of 5.5% compounded monthly, by the time you retire at the end of 45 years, you could end up with nearly $1.2 million in savings.  

 

Less than a quarter of this amount, just $270,000, is the original principal that you’ve saved over time. What this means is that that much of your gains over 45 years have come from compounding returns. How does this situation look if you decided to delay retirement savings by a decade?

Source: Broadview Macro Research

Well, if you decided to delay your retirement contributions by ten years, using the same assumptions as before, you could end up with almost half the amount saved compared with starting ten years sooner. This illustration shows that you might accumulate $600,000 instead of having $1.2 million if you had started saving at 35 instead of 25. In fact, if we continued this illustration by delaying savings in ten-year increments, we find that the amount saved continues to decline at a precipitous rate.

 

The point here is that if you’re looking for a simple act to get you on the right track toward retirement security, start by saving early. To be sure, the power of compounding requires three simple components: a contribution rate, a return, and time. Of these three factors, the decision to begin your savings journey is the easiest one to control and is an important reason why starting now is crucial to rebuilding the first leg of your retirement savings stool.

Saving Outside of an Employer Plans

Establishing savings outside of an employer plan is another essential leg of the retirement planning stool. Now, as we pointed out before, merely parking your money in a bank account won’t generate the kinds of savings benefits that may have been available decades ago.

 

In fact, allowing your money to accumulate in a bank account alone over the past ten years might have left you worse off financially when accounting for inflation’s effects. So, where else can you store your money for growth while preserving the purchasing power of your savings? Consider real estate.

 

Ownership Builds Inflation-Protected Savings

Everyone needs a place to live. There are indeed many tradeoffs between renting and owning a home. On the one hand, renting means little to no maintenance costs and gives you the option of relocating when your life circumstances change. On the other hand, rent payments are effectively a 100% loss on financial savings.  

 

Indeed, there are some costs associated with homeownership. Even so, the fact is that each month a portion of your mortgage payment goes toward building equity that you can use in the future. And the longer you pay down your mortgage, the higher the part of your payment goes toward building up your savings.

While the housing market has experienced price volatility over the years, history has shown that at a national level, home values generally rise over time and at a rate that outpaces inflation. This means that making the simple decision to own versus rent might enable you to build savings that are preserved against the ravages of inflation. How can homeownership specifically benefit you in retirement?

 

Well, assuming your mortgage is paid off by the time you retire, a couple of benefits tend to accrue. First, you will need a place to live during retirement, and owning your home outright is a way to ensure against rising housing costs over time. In fact, owning a home and paying off your mortgage as you enter retirement could lead to household expenses that are between 20-30% lower depending on the size of your pre-retirement mortgage payment.  

 

Another retirement benefit of ownership is the value stored up in equity. For example, you might choose to downsize your family home in retirement. And if you decide to purchase a less expensive home, the difference between your sale and purchase can lead to cash available for retirement savings.  

 

As of 2020, the IRS allows married couples filing jointly to avoid paying taxes on gains of up to $500,000 on the sale of a primary home. This potential tax-free gain illustrates how homeownership is another way to shore up a crucial leg of your retirement planning stool, notably in a low-interest-rate environment.   

Delay Your Social Security Benefits

Social security is the final but foundational leg of the retirement planning stool. As discussed earlier, this government program is likely to face several challenges in the years to come. While some individuals argue social security will eventually fail, a possible outcome is that Congress will act in some way to change this vital program by reducing future benefits, increasing taxes, or some combination of the two.  

 

So, what can you do to make the most of this critical part of your retirement plan in light of the ongoing uncertainties surrounding this entitlement program?

 

First, it’s vital to note that the choice you make between taking Social Security benefits sooner rather than later can mean the difference of thousands of dollars in lifetime income.  

 

As of 2020, the Social Security full retirement age (FRA) is between 66 and 67, depending on what year you were born. FRA represents the age at which you may receive your full benefits based on your income history.  

 

Now, the Social Security Administration allows you to begin taking benefits as early as 62 so long as you meet specific criteria. However, taking social security before your full retirement age means that you’ll receive less of a benefit than you otherwise would be entitled to.  

 

For example, compared to waiting until the age of 70, taking retirement benefits at 62 could mean the loss of lifetime income of over $180,000. This outcome assumes that your salary at age 40 is $100,000 per year and that you receive retirement benefits until age 90.

 

The point here is that if you plan to incorporate social security benefits as part of your retirement plan, then a simple act you can take to shore up this foundational part of retirement planning stool is to delay taking benefits for as long as possible.

Rebuilding the Broken Retirement Stool

The road to retirement is not as straightforward as it used to be. There was a time when the simple concept of the three-legged stool of employer, financial institution, and government support could ensure individual financial comfort throughout retirement. By many measures, the structures making up the legs of this metaphoric stool are broken. 

 

Today, establishing a sense of retirement security has increasingly become the responsibility of individuals over once trusted institutions.  If you want to rebuild the retirement planning stool, then you’ll need to start by taking a more active role in your employer retirement plan, and crucially beginning your contributions sooner rather than later. And while bank deposit rates are meager today by historical standards, responsibly using your home as a way to store up inflation-protected value might provide you with a useful cash resource as you near retirement.   

 

Finally, social security benefits aren’t likely to go away, but you can make the best of an uncertain system by maximizing the benefits available to you throughout retirement. Either way, taking some simple steps today can help you rebuild the broken retirement stool to suit your individual needs in this complex and challenging economic environment. 

About the Author

Peter Donisanu
Peter Donisanu is Chief Financial Strategist and President at Franklin Madison Advisors, Inc. Franklin Madison Advisors is a fee-only fiduciary financial planning and investment management firm based out of Pittsburgh, Pennsylvania and serving clients nationally. We exist to serve a generation that has been underwhelmed by traditional paths to financial security and independence.

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